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As the deadline nears for an EU directive intended to enhance the protection of European investors, it is becoming clear that it will, instead, curtail their access to lucrative opportunities in the US as hedge funds based there choose not to comply.

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Many US hedge funds are choosing to stop marketing their products in Europe rather than comply with the Alternative Investment Fund Managers Directive, which comes into force on July 22, according to industry reports.

Under the AIFMD, which is also intended to reduce systemic risk, only funds registered in the EU will be allowed to market their products there. While some larger US funds are registering, the cost and complexity of the process means many medium or small funds will not comply.

Investors wishing to invest in the funds will be dependent on provisions for “reverse solicitation”, in which they initiate contact with the fund rather than receiving its marketing, or country-specific national private placement rules, a mechanism allowing non-European managers to market funds.

With more than three quarters of global hedge fund assets under management run by funds based in the US, the AIFMD will severely restrict the choices open to investors in the EU.

Preqin’s head of hedge fund products, Amy Bensted, said: “Quite a large proportion of US-based fund managers have told us over the last year they would not market in the EU as a result of AIFMD so there could be a pull-out of some US funds from the region, or they just may rely on reverse solicitation.

Anecdotally, the US guys do seem quite wary of AIFMD and are focusing on their local markets to raise new capital, which is very healthy at the moment.”

Mikael Johnson, a lead partner, alternative investments, at KPMG, said: “US managers registering under the AIFMD have been primarily large hedge fund organisations with diverse businesses and asset pools. That represents a small minority of US-based managers. Everyone else is taking a ‘wait and see’ approach, leveraging private placement regimes where possible or relying on reverse solicitation otherwise.”

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The increased burden and cost of compliance are significant hurdles for US managers already grappling with greater regulation in the US.

Bensted said: “There are quite a lot of local regulations for these managers to cope with at home. Many don’t want to take on the extra burden, or indeed costs, of having to cope with regulations overseas.”

The economies of scale associated with compliance largely explain why most of the funds that are registering are those with larger assets under management. Under the AIFMD rules, only EU alternative investment fund managers managing EU alternative investment funds can market via the “passport” introduced by the directive. The passport allows alternative investment fund managers to market EU alternative investment funds to EU professional investors in their home member state, or in other states subject to certain conditions. All other managers, including non-EU alternative investment managers managing EU or non-EU alternative investment funds, must comply with national private placement rules, which differ in different states.

Johnson said: “This is not practicable to the vast majority of American-based managers. Many US hedge funds would have to change their business models to do this, which is why so many are sitting on the sidelines.”

BNY Mellon recently found 93% of alternative investment managers they surveyed saw the increasing cost of supporting risk and compliance data, and its reporting, as a challenge given the additional requirements of AIFMD.

One European hedge fund director suggested that for a large alternative investment fund manager the annual cost of compliance could be as high as £1.5 million.

Managers’ ability to pass those costs to the fund is still unclear. The BNY Mellon survey showed 26% planned to pass on at least some of the cost, impacting the total expense ratio investors pay, 29% would not pass on costs, while 45% were undecided.

Investors’ tolerance of paying these costs is low. Paul Berriman, director at Towers Watson Investment Management, commented: “People are focusing with laser-like precision on fees. US managers will have to either absorb the additional cost of AIFMD compliance themselves or choose not to have clients in Europe.”

Smaller and medium-sized funds will find it harder to suck up the extra fees, exacerbating the problem for
European investors.

David Walker, an associate director at Cerulli Associates, said: “It may be precisely the smaller non-European managers that do not have the resources, or wish, to become AIFMD-compliant that Europe’s large alternatives allocators are looking for.”

Limited choice

The US remains the largest and best-performing pool of hedge fund talent. Hedge Fund Research data shows that over 60% of hedge funds are US-based, representing over 76% of total industry assets under management. The HFRI North America Located index has also outperformed the HFRI Europe Located and HFRI Fund Weighted Composite indices, with returns of 17.58%, 11.11% and 16.21%, respectively, between the start of 2012 and the end of March 2014.

Christopher Parkinson, head of manager research at investment consultants Cardano, said: “US groups largely moving to a reverse-enquiry situation presents a challenge to younger investing organisations in Europe, or those who only recently started investing directly in hedge funds, as they won’t have the sea of networks into the US hedge fund market versus a well-established investing organisation.”

The rules around private placement have also tightened significantly across the region, making this route increasingly difficult for investors in many countries. Under Article 42 of the directive, some member states are imposing stricter rules on non-EU managers marketing funds to investors.

Germany and Denmark require managers to appoint one or more firms to perform “depositary-lite” duties (safe keeping of assets, cashflow monitoring and oversight) outlined in Article 36.

Bill Prew, founder and chief executive of specialist depositary provider Indos Financial, said: “We understand France has also imposed a depositary-lite obligation, however in practice, it is expected to be very difficult to market a non-EU fund to French investors.”

Holland-based independent fund selector Jeroen Vetter noted: “AIFMD is hugely restricting for European investors’ hedge fund manager choice. While investors can subscribe directly, only a very limited number of investors will be able to do so, not least because of the increasing regulatory pressure investors face.

Where managers are not able to market themselves, it will also be harder for investors able to go direct to get a fully informed view of the range of managers in the market.”

Alternative access

By restricting access to US managers, the AIFMD could create a significant opportunity for the beleaguered European fund of hedge funds industry. An AIFMD-compliant fund of funds would be able to leverage its in-depth industry knowledge to access noncompliant US managers through reverse solicitation.

TWIM’s Berriman said: “Funds of hedge funds that can articulate the value proposition of providing access to noncompliant US managers, and can provide evidence of that working in practice, stand in good stead to benefit in the post-AIFMD world.”

US hedge funds appeared to agree this route could prove lucrative. The chief risk officer at one multibillion-dollar US-based hedge fund said: “From our perspective, AIFMD significantly reduces the types of clients and geographies we are able to solicit business.” The fund, which returned nearly 20% last year, was not planning to register under AIFMD. He continued: “The market naturally moves to find ways to provide access. Funds of hedge funds seem like the most logical option.”

Funds of funds’ role could become particularly interesting once the window for private placement in countries including the UK and Nordics closes in 2018. The non-EU AIFM regime is still under construction with no release date in sight.

Henry Watkinson, director at fund of hedge funds Headstart Advisers, which was going through the AIFMD registration process, said: “The vast majority of good new hedge funds are coming out of the US, but are not going to bother with AIFMD. Many of the best funds are also soft-closed or closed and can get by on reverse solicitation. This will cause European investors to be largely precluded from seeing any of these funds. We see this as a strong opportunity for the European fund of hedge funds industry to provide access to those managers.”

--This article first appeared in the print edition of Financial News dated April 21, 2014